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How and why is it important to identify potential strategic default behaviour as early as possible?

Strategic defaults are becoming a critical issue; the prominence of this trend is particularly important in the USA and is starting to have a similar significance in other regions. 

A strategic default is the decision by a borrower to stop making payments (i.e. to default) on a debt despite having the financial ability to make the payments.

Strategic defaults are particularly associated with residential and commercial mortgages, in which case, this activity usually occurs after a substantial decline in the value of a property. The diminished value of real estate in these instances means that the outstanding debt that is owed is often considerably greater than the market value of the property.

The impact of the global credit crisis has been widespread, beginning in the US with mortgage products as the primary driver, the impact has continued to influence other debt and consumer spending. As well as the reduced availability of home equity, other debt burdens have remained high for many consumers as institution began to increase collections activity. 

As the crisis has unfolded, the rise of unemployment has become a primary consideration in customer management, from the increasing default behaviours, to the challenges of acquiring profitable new customers and the greater economic goal of moving the recession into recovery.    Because the crisis is not yet seen as over, the credit market in the US continues to be slow, with originations down across all products, primarily as a result of low demand in the market and a tighter lending criterion. While demand for new credit has slowed, the consumer debt burden remains high for all risk grades, with outstanding balances at record highs.

Delinquency trends continue to increase across most consumer credit products and risk grades. While delinquencies in mortgage-related products began increasing as a result of high risk mortgage loans and declining property values in bubble markets, increasingly they are now largely a function of unemployment and debt burdened consumers.

Continued property value declines in bubble markets and rising unemployment rates across the U.S.A have led to increased exposure and risk for lenders. As the marketplace continues to slow, lenders need to create a balance between loss mitigation and long term profitability of the existing customer base.

Why is understanding strategic default important?
In the first instance, understanding of this behaviour is likely to reduce exposure to further losses, such as loans for redevelopments, renovations and other modifications. Secondly, with enough understanding of the issue it is possible that lenders could attempt to convince these borrowers to change their mind and therefore continue to be valuable customers to the business.

There are a number of key questions to be considered when considering the issue of strategic defaults.

1. How do we identify"strategic default" behaviour?
2. Can we identify strategic defaults early in the customer lifecycle?
3. If behaviour can be predicted at origination, should the underwriting process be different?
4. How large is the potential impact of strategic default, what does this customer segment look like?
5. How is it different from other types of mortgage defaults?

Strategic Defaults: A typical behavioural profile

How to manage the issue
Strategic defaulters raise some interesting questions related to account management, such as how much time and attention should be devoted to these segments from a pre-collections and loss mitigation perspective, and do businesses have the appropriate pre-collections and collections actions to address this specific issue?

The suggested steps for many organisations are to:

1. Produce a specific analysis on own portfolios; determine implications for non-real estate borrowers as well as matching with current loan to value (LTV) data for a more accurate read on negative equity impact
2. Match against any income data obtained during collections process to verify that strategic defaulters are in fact able to pay, but choosing to default
3. Revisit loan modification decisioning algorithms
4. Develop different loan modification offers and sequencing to screen out strategic defaulters, e.g. Accelerate principal repayment as part of loan modification
5. Develop strategies and offers for convincing strategic defaulters to change their mind, e.g. Equity risk sharing arrangements, small principal reduction as incentive

The new economic environment will provide many opportunities as well as challenges.